A O U
Keiretsu

Keiretsu Explained.


In the summer of 1990, my wife and I visited our son, a Marine stationed in Japan, for two weeks. During that time we traveled close to 1000 linear miles by rail and car, so we got to see a fair piece of the main island. I spent several days just walking around observing (snooping) in the small city of Iwakuni which is about 500 miles south of Tokyo. Following are some conclusions.

While there is great world pressure on Japan to increase imports to offset exports, I left Japan with the distinct impression that will never happen, can't happen. It can't happen because any meaningful relaxation of import barriers would seriously jeopardize their economy. However, in the one area where imports would NOT threaten but would, in fact, significantly raise their standard of living is agriculture.

For example, I estimate the average Japanese spends several times as much for food, on a relative basis, as his American counterpart. Almost everything (clothes, appliances, etc.) costs significantly more than in the USA, both on a relative (he has to work more hours to earn enough to buy the same TV, pants, etc.) and a real dollar/yen ($4.50 a piece for oranges, $1.25 for a can Japanese Coca Cola, etc.) basis. The yen at that time was trading 140-145 to the dollar. The "Economist", an international magazine originating in Britain estimates fair value for an equivalent basket of goods at 200-205 yen to the dollar (Jan 1991). That would bring the cost of the can of Coke to $1.75 - $1.80, and make Japanese exports even more attractive (relatively cheaper) in the USA.

After leaving Tokyo, we took the Shinn (a high speed train which is a model of comfortable and efficient mass transportation) to Iwakuni (500+ miles south) where we stayed for about 10 days. I estimated 25-40% of available land outside the cities (usable for human purposes roads, buildings, etc.) is being used for agricultural staples (mostly rice, beans or tea). I am much impressed how every square meter that can grow something does. The Japanese are extraordinarily proficient in their use of land, far more so than has ever been my experience. If I were to say 100% of usable land was being used that would be an exageration. If I were to say 98% of available land was being used, it would probably be an underestimate. It's useful to remember the main island(s) of Japan is mostly mountains.

The Japanese standard of living (SOL) is, and will continue to be, severely restricted by lack of usable land. This comes about in two ways.

I'm convinced the Japanese "powers that be" ('keiretsu' in Japanese) would never take the chance of any agricultural import relaxation, no matter how severe the cost to their population, for fear of spreading the lowering of barriers to other segments of their economy where they are extremely vulnerable.

A simplistic example will serve to demonstrate what I mean: Take a simple ball point pen (any item will do). Say that pen costs a dollar (or yen, deutshemark, krona equivalent) to produce and yield a fair and reasonable share of that dollar (without arguing what that should be) to each stage of capital and labor between raw materials and the consumer. In the USA, or any competitve economy, the pen will sell for + or - $1.00. If the price exceeds $1.00 due to some stage of the process generating excess profits, it will quickly attract competitors/capital seeking those excess profits ("Hell, I can sell/make it cheaper than him and still make a buck!"). As the price falls under $1.00, the less efficient competitors get driven out by losses ("Hell, I can make more money raising hogs than making pens!"). There are many other factors that come into play (quality, subsidies, regulations, tarriffs, etc.) but that's pretty much how it works in a free economy.

But that's not how it works in Japan. First of all, they essentially have no raw materials and therefore have to import them. Right away they start at a disadvantage to other countries, so they have make that up with more productive labor (cheaper, more efficient or better quality). I suspect their energy cost may be cheaper also via greater use of nuclear power. At any rate, they have to overcome the disadvantage of imported raw material (relatively expensive by definition) somehow. Initially (postwar) they did it by cheaper (lower hourly wage), more productive (higher output per wage) labor and "back scratching" relationships in the production and distribution chain.

However, the "laws of competition" dictate any advantages (via labor, etc.) will be eventually overcome. The more pens made, the more money earned causing their standard of living to rise. As the standard of living rises, the costs of living (wages, goods, "pens", etc.) go up. As that happens, their initial edge becomes eroded; labor gets less "hungry" (higher wages, shorter hours, work schedules, etc.), management becomes "fat" (inflated salaries, perks, bloated staffs, etc.,) political leaders get complacent (plenty taxes for the pork barrels & "much needed social programs.") and so the pens cost increasingly more to make. At the same time "hungrier" competitors are forcing their own costs down, reducing relative advantage to the Japanese. And at some point initial advantages disipate to the point where the domestic "pen" industry feels threatened and must find less traditional means to survive. Ergo "Keiretsu".

The Japanese formalized keiretsu (loose translation = brotherhood or maybe the age old "You scratch my back and I'll scratch yours.") initially to gain a toehold in the competitive process and likely as a survival mechanism. Keiretsu is the process where companies are interlocked via stock ownership to each other. Simplistically the raw material suppliers own stock in the manufacturers who use their product. Who in turn own stock in the suppliers .... the distributers ...., who in turn own stock in...... who own stock in.......... You get the idea. The ownership of all phases of the pen making/distribution/sales process becomes intricately intertwined. Being in the kieretsu affords stability to its members. But it also leads to complacency and "fat".

It becomes difficult if not impossible for new entrants to break in. What good is it for you to manufacture a cheaper pen if distribution costs, for example, are driving the final cost above the other pens? Why should the distributer (or retailer) handle your (or any other) pen when he has a vested interest (via stock ownership) in the one he already handles? The end result is the elimination of domestic competition. With no internal competition to inhibit excess profits, the original $1 pen now costs the Japanese consumer maybe $1.25. (Example the cheapest calculator I could find anywhere was a simple four function model for about 2,000 yen or $14 American. The equivalent sells in discount stores in the US for well under $10.)

The "pen" example leaves a $.25 surplus or excess profit. The interesting thing is the way I believe the surplus is being used by Japanese companies. Some is used to increase wages, salaries, perks, tax revenues, etc. raising their standard of living as is to be expected. However, I believe a very sizable proportion of it is used to subsidize exports, allowing them to sell $1.00 pens in the export market for say $.90 by using excess domestic profits. Which in turn keeps the Japanese factories working (maybe the "pen" factories need to produce more than the domestic market can handle to stay viable ("economies of scale", etc.).

In other words, they are using domestic consumption to subsidize exports. Keep in mind the relatively wealthy, concentrated population of Japan (125,000,000) is a pretty fair market in its own right. How long they can keep this up is beyond me, but it is obvious the present circumstances will prevail for the forseeable future. I think inflation (and complacency) will eventually catch them up, but I have no idea how long that would take. It might be already Why else build factories in Taiwan, Mexico or the USA for that matter?

It is generally believed in the USA that the Japanese "dump" commodities below cost of production (computer chips, cars, etc.) for the sole purpose of "gaining market share". If you think about it, "dumping below cost to gain market share" in a freely competitive market doesn't make sense. Implied in that strategy is that losses incurred will be recovered by surplus profits later on; but the "law of free competition" says surplus profits will attract competition inhibiting any loss recovery. However it does make sense if export losses are covered by higher prices on domestic sales in Japan (protected from both foreign and domestic competition) which in turn keep the factories running. Any threat (i.e. cheaper imported goods) to those higher prices would, of course, jeopardize their entire production process. Especially if labor, management, and government have gotten very "fat" during the good years.

Keiretsu goes a long way to explaining the perceived "superior" Japanese efficiency and management techniques compared to the American way of doing things. It's not very hard to look smart overseas when you have a builtin hidden subsidy for exports. How else could Japanese "pens" (cameras, calculators, Tv's, stereos, etc. ) be cheaper in Iowa than in Tokyo? And it's not very hard to make a better quality product when you have a hidden subsidy to invest in quality control.

No question, they are vunerable in the area of agricultural imports. I can't help but believe if the Japanese working class (blue and white collars) knew how much more they were paying for clearly inferior food ($18.00 for a bunch of grapes, $3.00+ lb for rice) than their counterparts in the rest of the world that changes would come rapidly. It's absolutely unconscionable for Japanese keiretsu to not allow food imports. Any loss to Japanese Gross National Product from diminished domestic agricultural income would be offset many times over by the dramatic increase in their standard of living from freed income now going for vastly overpriced food (by world standards) and the freeing of incredibly scarce land for more productive purposes (jobs, housing, etc.).

Vacant (or unutilized) land is now so scarce (far beyond anything an American who hasn't seen Japan could conceive of), the average Japanese family won't own their own home until the head of house hold is in his 50's (as compared to the 20's in the USA). Agricultural imports alone could drop that expectation by a decade or more by freeing as much as 50%, or more, of the total usable land now dedicated to growing rice, beans and tea. However, the same mentality that practices keiretsu views any relaxation of import barriers for food as a threat to entrenched practices in other industries, no matter how beneficial to Japan as a whole. And that's probably true.

Incidentally, keiretsu can only work in a closed noncompetitive society. Ironically, the very system (keiretsu) that helped Japan to become a "Super Competitor" and consequently wealthy, will be the same one that will hold the domestic Japanese population hostage to ever higher prices, and an ever lower standard of liv ing. Foriegn competitors, impelled by the force of Japanese competition, will, via innovation (and the cutting of their own "fat"), continue to become more efficient (driving costs down), while Japanese production becomes lazy from no real competition, until the point where inevitably rising domestic costs/prices can no longer sustain the export subsidy. (Foreign "pens" will eventually become so relatively cheap in the export market, the shrinking "surplus profit" from the Japanese domestic market will no longer be enough to compensate for domestic inefficiencies, causing a drastic contraction of domestic industry.)

It is an imploding spiral whose resolution can only come with drastic change, as any reading of history amply demonstrates. It may take decades, generations or even centuries in a slow moving world, i.e. the mandarin regieme in China, the various "Empires", (British, Roman, Byzantine etc.). In the USA, it goes under various names "Horizontal/Vertical Integration", "Consortium", "Diversivication", Professional or Trade Association "guidelines", governmental price regulation (rent control, resource allocation, confiscatory and/or directed taxation, protectionist tarriffs, etc. ). Our saving grace (at least I fervently hope and believe) is our antitrust laws when they are vigorously applied, our "native American ingenuity" and inherent respect for fair play (I know you'll forgive a bit of good old American chauvinism).

Japanese rationales for Status quo

The argument is made the farmers have too much political influence to allow agricultural imports, but I believe that is just an excuse. The fact is most of the land is under corporate (keiretsu) control, either through ownership or complicated leasing arrangements (probably akin to Land o' Lakes control of much of our domestic dairy industry). You know something is wrong when land worth millions of dollars an acre is used to grow a few hundred dollars worth of rice or tea. Furthermore, while Japanese utilization of available land is nothing short of phenonemal, they can't begin to compete with American per acre yields or cost. The nature of the land will simply not permit it. Very small plots interspersed in rough terrain just do not lend themselves to mechanization or large scale land practice (aerial spraying, etc,). The AFBF estimates the average American farmer feeds 130 people. The average Japanese farmer feeds 3 people.

The argument is made the Japanese are xenophobic and insist national security requires they have a domestic food supply. That argument is offset by the high value of the land, i.e. each acre of warehousing could contain years of production from hundreds of acres of land, freeing it for more productive uses (factories, living space, roads, recreation, etc.). Further, the world is entirely too dependent on Japanese production for any meaningful boycott or embargo to last nearly long enough to exhaust those warehouses, short of Japanese aggression to another country.

The argument is made the Japanese distribution system is not capable of, or amenable to, American style distribution. While factually true,

The argument is made that somehow US agricultural exports are re lated to:

However... we aren't asking to sell them peanut butter (They can get it a lot cheaper elsewhere anyway), just the opportunity to sell some dairy products or grain or even peanuts. In the final analysis, does the Japanese housewife really care (or should she even have to) about American tax/subsidy problems? If she spends less for rice, she'll have more for "pens" (domestically produced Japanese products) and a great deal more land area to spend it on.

It is clear to me the Japanese business infrastructure via kieretsu(s), as well as considerable political means, will never allow any significant increase of imports into Japan (agricultural or otherwise), no matter how beneficial to Japan in the long run. The only avenue (if any at all) around it would be to somehow reach the Japanese consumer directly. My experience indicates the Japanese housewife is every bit as frugal and careful with her food shopping as her American counterpart. Just how that to reach that shopper is beyond the scope of this paper.

Prepared for: Dean Kleckner, President - American Farm Bureau Federation

Prepared by:Gösta H. Lovgren, member - New Jersey Farm Bureau

Addendum 04/15/91

Since this was originally written, the economy of Japan has begun to undergo serious change, that is, if you can believe the "conventional wisdom" of the media. The 35% (so far) devaluation in the Japanese stock market is eroding the capital base of Japanese banks and companies. Of course most of the upward valuation was merely trading incestuous paper between related parties (bookkeeping) that had no real bearing on value from goods produced. If I own a piece of property that I value at a million dollars (but may only be able to produce $10,000 in goods and services) and the bank agrees with me (maybe it owns a share of it too), the value of my company's stock will be increased by some multiple of that million. The bank can then "print" (loan) money (inflated currency by definition) based on the inflated collateral value of my stock (and property). That money can then be used to purchase real (better) value (maybe US companies and property, which would be severely undervalued by noncompetitive Japanese standards).

The problem comes in if I ever have to make good on that collateral property on which my wealth is based. If I can find no one to pay $1, 000,000 for my $10,000 property both my bank and me are in serious trouble. The problem doesn't even have to come from my end.. Maybe the bank is only now coming under accepted international reserve standards and has to get its act together. No matter the reason, it's happening. Keiretsu coming home to roost.

What happens now? Do I let my Japanese holdings fold (culturally unpalatable) and concentrate on the foriegn holdings I previously purchased? That's going to be tough. I got fat in a keiretsu economy that really doesn't exist outside Japan and am going to find it difficult to compete without the hidden domestic "subsidy" I had in Japan. I'm probably going to find the "undervalued" overseas properties I bought with my inflated currency weren't so undervalued after all in the world market. Sellers only sell when they think they can do better with their capital elsewhere. Maybe much of what I bought was merely debt that looked good in inflated currency.

Or do I fold my tents overseas and tend to business at home? That's going to be tough too. I'm going to have to find buyers for my overseas properties. The only way I bought them was by being the highest bidder. In other words no one was willing to pay as much as me, so how I am I going to get my money back? The answer is, I'm not. I'm going to have to take a loss, probably a significant one. Is the loss going to cover my previously inflated money? Maybe if I bought at a 120 Yen/dollar and it's now a 240 Yen/dollar (and the property hasn't cost too much to maintain, update, etc, or hasn't lost too much money or ....), but then again it depends on how bad I *really* overpaid. So I'm probably going to take a beating overseas and now I have to take what's left and hope to be able to cover at home. (Maybe America will get Rockerfeller (?) Center back at a bargain basement price after having taken Japanese money to bail out some extended creditors.)

Either way, I'm a sick kitten. How sick I get depends on a lot of factors but it all boils down to the fact that a $1 pen is really only worth $1 over the long haul. The imploding spiral.

**********Addendum again****** 04/95*********

The Japanese Yen has appreciated beyond even what I would have thought unthinkable. It's currently trading around 85Y to the $. When this paper was first written it was around 140Y to the $ and remember that "fair value" in a free market puts it around 200Y to the $.

What that means is that Japanese goods have gotten even more expensive in the US and US goods are even cheaper yet. My original $1 American pens would now sell in Japan for about 60 cents (If the J government and Keiretsus would allow them to be imported) while the same pen made in Japan would cost the Japanese consumer somewhere around $2 (in yen) to compensate for the devalued dollaryen ratio. In other words the Japanese consumer has gotten hit even harder to subsidize Japanese exports.

Their is a little bright side for the Japanese though. As the world currency standard is still the America dollar, it means it takes fewer yen to purchase raw materials. Whether that's enough to offset higher prices is problematical. Further complicating the picture is the fact that American goods are now even *cheaper* to import. That has to be creating terrific pressures on the Keiretsus.

Yet another Addendum (4/96)
The Yen is currently trading around 105 or so to the $, creeping up(down) for the last several months. While watching this phenomenal Yen valuation, I have a vague uneasiness its valuation is somehow being manipulated by world governments to prevent a collapse of the Japanese economy and consequent probable world depression. For example, what would happen to the US if all Japanese held debt and property were suddenly thrown onto the open market? What would happen to the dollar? I honestly don't know but I don't think it would be very good for anyone.

End of Keiretsu


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